Interrelations of U.S. market fears and emerging markets returns: Global evidence

• DOI: http://doi.org/10.1002/ijfe.1677
• Published date: 01 January 2019
• Author: Ghulam Sarwar,Walayet Khan
• Date: 01 January 2019

RESEARCH ARTICLE

Interrelations of U.S. market fears and emerging markets

returns: Global evidence

Ghulam Sarwar

1

| Walayet Khan

2

1

Department of Accounting and Finance,

College of Business and Public

Administration, California State

University, San Bernardino, California,

USA

2

Schroeder School of Business, University

of Evansville, Evansville, Indiana, USA

Correspondence

Ghulam Sarwar, Department of

Accounting and Finance, College of

Business and Public Administration,

California State University, San

Bernardino, CA.

Email: gsarwar@csusb.edu

JEL Classification: G11; G15

Abstract

We investigate the interrelations between U.S. stock market uncertainty (VIX)

and equity returns in several emerging markets (EMs) in an integrated

multivariate system that allows the interactions through the first and second

moments of VIX and return processes. Our VARMAX‐CCC‐QGARCH model

finds significant interactions in the covariance terms of VIX and EM returns,

which facilitate risk transmission. Changes in VIX negatively affect EM returns,

which also significantly affect VIX changes. We find that VIX changes and EM

returns collectively have predictive ability for each other. Further, VIX shocks

contribute 22–42% to the prediction error of EM returns. Our results underscore

the importance of capturing interactions between VIX changes and EM returns

through their variance–covariance matrix and have important implications for

global diversification, flight‐to‐safetychoices, and hedging the cross‐marketrisks.

KEYWORDS

diversification,emerging markets, variance–covariance matrix, risk transmission, VARMAX‐

QGARCH, VIX

1|INTRODUCTION

The financial liberalization and capital markets develop-

ment in emerging markets (EMs) for more than two

decades produced substantial increase in information,

labour, capital, and trade flows across countries enhancing

global connectivity and market integration (Bekaert,

Ehrmann, Fratzscher, & Mehl, 2014; Rapach, Strauss, &

Zhou, 2013).The effect of this interconnectednessis evident

in capital markets as uncertainty and turmoil in one major

market immediately impacts global markets. However, the

existence, magnitude, and duration of cross‐border effects

of heightened uncertainty in one market on other equity

markets remain an ongoing empirical question.

In integrated global equity markets, the equity market

returns of EM may be linked to U.S. and global market

risks through trade and investment relations, herd mental-

ity, and fads among investors (Bekaert, Ehrmann,

Fratzscher, & Mehl, 2014; Lin, Engle, & Ito, 1994; Rapach,

Strauss, & Zhou, 2013). Further, the interrelations

between the U.S. market risks and emerging equity market

returns may occur through both the first and second

moments of return processes. EMs continually offer attrac-

tive investment opportunities for global investors due to

their unmatched growth, high risk/return trade‐off,

enhanced investment opportunity set, and a lower down-

side beta than the upside beta (Bekaert & Campbell,

2014; Bekaert, Campbell, Lundblad, & Siegel, 2011).

The Chicago Board Options Exchange (CBOE) Vola-

tility Index, or VIX, has received greater attention after

the global financial crisis as a key tool to gauge the inves-

tors' fears and market uncertainty. The VIX measures the

market expectations of short‐run (30‐day) U.S. stock mar-

ket volatility implied by the Standard & Poor's 500 index

option prices (CBOE, 2017; Whaley, 2000; Whaley, 2009).

The VIX is used as a measure to evaluate the cross‐

country volatility/returns relations due to its “forward‐

looking”nature and its proven reliability of investors' fear

Received: 6 November 2017 Revised: 4 August 2018 Accepted: 9 September 2018

DOI: 10.1002/ijfe.1677

Int J Fin Econ. 2019;24:527–539. © 2018 John Wiley & Sons, Ltd.wileyonlinelibrary.com/journal/ijfe 527